5 Tips for Savvy Target-Date Fund Investing

Retirement investors worried about the safety of their 401(k) plans need to take a close look at the holdings of their target-date funds. While the funds emphasize bonds as safe investments for employees nearing retirement age, most analysts feel that higher interest rates are inevitable, and bonds today might actually be riskier investments than stocks.

The future of interest rates is the million-dollar question for target-date investors, says Brooks Herman, head of research and data for BrightScope, an analytics firm that studies and evaluates 401(k) plans.

Target-date funds assets grew by 20 percent during 2012 - rising to more than $500 billion from about $420 billion at the end of 2011 - according to the latest annual oversight report from BrightScope released Tuesday. The financial information company looked at 425 funds offered in 48 families of funds from 38 fund companies. It also said another $250 billion of target-date fund assets are placed in restricted and customized funds not included in its study.

Target-date funds burst on the retirement scene following enactment of new rules in 2006 that encouraged employers to improve the offerings in their 401(k) retirement plans. These expanded choices led to offering employees a "hands off" mutual fund that would be professionally overseen without the employee's involvement.

The concept of a target-date fund is tied to an employee's projected retirement date. At regular intervals, the funds are automatically adjusted, or balanced, between different investment holdings to reflect market behavior. Additionally, as the owner's projected retirement date gets closer, a target-date fund's holdings are automatically moved out of stocks and other higher-risk investments and into bonds and other lower-risk holdings. These "glide paths" are designed to reduce holders' risk of being hurt by a big market swing from which they can't recover as they near retirement.

However, the relative safety of target-date funds came under scrutiny after many funds suffered big losses during the 2007-2008 market decline. It turned out there were big variations in different funds' glide paths, and the funds were not as conservatively managed as many investors thought. Subsequent opinion surveys also found a widespread misconception among employees that the funds were either immune to or at least insulated from market losses.

BrightScope evaluated the performance of 43 families of funds that have been offering target-date funds long enough to have track records. The company based its grades on five measures: company and organization (given a 10 percent weight), strategy (15 percent), performance (30 percent), risk (25 percent) and fees (20 percent).

The company noted that its ratings are based on the lowest-priced shares of target-date funds offered by each fund family, and investors may not be able to purchase these shares in their own retirement plans. It cautioned that higher-priced share classes from the same families might not warrant the same overall grade awarded to that family.

In evaluating target-date funds, here are five variables that investors should consider:

1. Fees. Target-date fund ownership is not free, contrary to the beliefs of many 401(k) investors who were polled in earlier surveys. Recent changes in federal disclosure rules have made fund fees easier for 401(k) owners to see on their regular statements. BrightScope says fees are declining but remain too high. "There has been substantial movement in fees this year," the BrightScope report says. "There are now 10 fund series with average expense ratios of 0.50 percent or lower, including three below 0.20 percent." However, it notes, "The average of all fees for the lowest-priced share classes remains at a stubborn 0.70 percent."

2. Risk. More recently, the riskiness of target-date funds has again emerged as a concern. "The target-date industry as a whole continues to pay too little attention to risk and is too aggressive, especially just prior to, and at the target date," the BrightScope report says.

Currently, the low level of interest rates has sharply increased the volatility of bond prices, making bond holdings possibly more risky than stocks. "Instead of attenuating the riskiness of the portfolio, managers simply provide more or less of it in the naïve belief that a replication of the Aggregate Bond Index [a widely used measure of investment-grade bond performance] will provide portfolio protection," the report says.

3. Interest rates. Market analysts are in strong agreement that interest rates will rise from their record low levels, and soon. But they don't agree when this will happen or on the size of the increase. Even investment professionals are challenged these days to evaluate the exposure of an investment portfolio to losses that would occur if interest rates increase. Unfair or not, owners of 401(k) plans have a similar responsibility. They thus need to know the composition of their plans' investment holdings.

Herman says some target-date funds have changed the structure of their bond holdings. Short-term bonds, like 90-day U.S. Treasury bills, are less affected by interest rate changes than longer-term holdings. Herman says investors should research and understand what's known as the "duration" of their target-date fund's bond maturities. Funds near their target date years will better weather interest rate changes if they hold short-term bonds. At the same time, Herman notes, short-term bonds have very small yields, and investors likely will be trading return for safety.

4. Glide paths. One significant key to understanding the risk and interest-rate exposure of target-date funds is to know the fund's glide path. This information is disclosed by the fund family that offers the target-date fund. There remains a substantial difference of opinion about how conservative target-date funds should be as they approach their respective target years.

In their earlier years, most target-date fund managers felt their funds holdings needed to include substantial percentages of stocks well after their target dates were reached. Due to longevity gains, they said, retirements were stretching out for longer and longer periods, and thus investment portfolios needed higher percentages of stocks to produce income gains that would provide income for these extended retirements.

More recently, some managers have adopted more conservative glide paths. BrightScope groups target-date fund glide paths into two categories: 1) Funds that are designed to reach their most conservative stock-bond ratio when the fund reaches its target year, which it calls managing "to" the target date. 2) Funds that don't achieve this ratio until after the target year has passed, a group BrightScope describes as managing "through" the target date.

"The percentage of equity at the target date, the other major indicator of TDF risk, remained at about 42 percent in December 2012," BrightScope reports. "The percentage of equity held at the target date by 'through' funds averages 48 percent, while the average equity held at the target date for 'to' funds is a much lower 31 percent."

With such wide variations, 401(k) investors who own a target-date fund should take steps to understand their fund's glide path strategy. In particular, Herman says, investors can read their fund's offering prospectus and see if their fund manager has the tactical freedom to unilaterally depart from the fund's glide path if the manager feels this is warranted by market conditions. Herman says the fastest way to know if a target-date fund has such managerial discretion is to open an online copy of its prospectus and search for the word "tactical."

5. Competition. Until recently, employees in 401(k) plans had little choice if their target-date fund charged high fees or followed investment practices that an employee felt were too conservative or risky. But competition is coming to more and more plans, BrightScope notes. Employers are demanding more target-date fund choices for employees, and the fund families are responding.

"Plan sponsors have been looking off-platform for more of their target date fund needs, whether their priority is fees, glide path or equity percentage at the target date," the report says. As a result, fund recordkeepers that previously offered only their own fund choices are adding the offerings of competitors. "Fidelity offers four target date fund families, JPMorgan now offers two and T. Rowe Price announced the release of their second target-date fund series in August of 2013," BrightScope says.